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The Subprime Mortgage Debacle A

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					The Subprime Mortgage Debacle:


By Wm. Robert Pope
                                                                    A Tax I                                $$ue?
      Congress has amended the Internal       determine how and when a discharge                  showing $200,000 in cancellation of
Revenue Code1 to create some tax relief       occurs. In this discussion, “discharge of           indebtedness income. The IRS will get
for subprime borrowers. The Mortgage          indebtedness” will, therefore, encompass            a copy. The taxpayer realizes phantom
Forgiveness Debt Relief Act of 2007 (the      non-judicial debt adjustments, as well as           income. Under the 2007 act, the income
“2007 Act”), effective Jan. 1, 2007,2 added   the discharge of debt in a bankruptcy.              realized from the discharge of “qualified
two changes to IRC § 108: § 108(a)(1)               In the 2007 act, congress targeted            principal residence indebtedness”
(E), excluding from a taxpayer’s gross        the borrower/consumer saddled with                  (“QPRI”) will be excluded from gross
income any income from the discharge          a subprime loan in the restructuring                income, even if the taxpayer is solvent.
of a “qualified principal residence            process. Discharge of indebtedness has                    Analysis of the new QPRI exclusion
indebtedness” (QPRI), and § 108(h)            always created taxable income.3 Before              involves two code sections: IRC § 108
defining the rules for that exclusion.         the amendment, debt discharge income                defines the conditions unique to the
      Before the 2007 amendment, IRC          was excluded from gross income by §                 exclusion and IRC § 121 defines the
§108 defined when and how income               108 if the discharge occurred in a case             “qualified residence.”
from the discharge of indebtedness was        under Title 114 or if the discharge occurred
excluded from g gross income. Section 108     while the taxpayer was insolvent.5 For
                                                            p y                                   A. IRC §108 Conditions for the QPRI
also imposes a specific penalty for that       example, assume that a taxpay was
                                                                        taxpayer                  Income Exclusion
exclusion, the reduction of tax attributes.   insolvent and made a deal wit a lender
                                                                            with                   1. The exclusion applies for debt
Technically, § 108 does not use the word      to reduce mortgage debt. The taxpayer                   discharged on or after Jan. 1, 2007 and
“discharge” in a “bankruptcy code” sense,     realized taxable income in an a    amount               before Jan. 1, 2010. Thus, any QPRI
whether in or out of court.                                             However,
                                              equal to the reduction. Howev that                      discharged during the years 2007, 2008
Otherwise, § 108                               income was excluded from th taxpayer’s
                                                                              the                     and 2009 will be excluded from gross
does not define                                 gross income under § 108’s in   insolvency             income.6
how or when                                     exclusion, but only to the exextent that the       2. The amount of the exclusion is limited
a debt is                                                                      the
                                                  reduction did not restore th taxpayer’s             to $1,000,000 for individuals filing
discharged.                                        solvency.                                          separate returns and $2,000,000 for
State law                                                 The 2007 act created a new                  individuals filing joint returns.7
and the                                                exclusion from gross i    income for        3. Qualified indebtedness is limited
bankruptcy                                               a solvent borrower o   outside               to debt incurred for (i) the purchase
code                                                                         this
                                                         of bankruptcy. In th way,                    of; (ii) the construction of; or (iii)
                                                                    congress p protected              “substantially improving” a qualified
                                                                           unw
                                                                       the unwise                     residence that is secured by the
                                                                        borrow
                                                                        borrower from a               residence.
                                                                         secon
                                                                         second mistake -                    IRC § 108(h)(2) refers to
                                                                         accepting a loan
                                                                         accep                        the definition of “acquisition
                                                                         reduction that
                                                                         reduc                        indebtedness” found in IRC § 163(h)
                                                                           crea
                                                                           creates a federal          (3)(B), defining home loans for interest
                                                                           income tax bill,
                                                                           inco                       deduction purposes. As a point of
                                                                            with no cash to
                                                                            wit                       clarity, §163(h)(3)(C) defines “home
                                                                            pay that bill.            equity indebtedness”, which was
                                                                                     Assume           not referenced in IRC § 108(h). Be
                                                                                r
                                                                            a residential             careful: a discharge of “home equity
                                                                                m
                                                                                mortgage of           indebtedness” will not satisfy the
                                                                                  $450,000, but       QPRI discharge exclusion unless the
                                                                                   the property       home equity indebtedness was used
                                                                                   value has          to substantially improve a qualified
                                                                                  declined to         residence. The home equity loan for
                                                                              $2
                                                                              $250,000. The           the car, boat or the Vegas trip will not
                                                                              le
                                                                              lender will             work; the general insolvency exclusion
                                                                                w
                                                                                write down            might apply.
                                                                                  the debt to      4. The language of limitations on
                                                                                  the current         reasons for discharge, § 108(h)(3),
                                                                                  value. The          reads awkwardly, at best, even for
                                                                                t
                                                                                taxpayer will         legislation, and contains no definitions:
                                                                            rec
                                                                            receive a Form                   Section (a)(1)(E) shall not apply
                                                                            109
                                                                            1099-C from               to the discharge of a loan if the
                                                                             the lender for           discharge is on account of services
                                                                             the year of              performed for the lender or any other
                                                                            the discharge,
                                                                                                                           continued on page 10


                                                                                                       MARCH 2009   |   Tennessee CPA Journal     9
The Subprime Mortgage Debacle: A Tax Issue?
continued from page 9

   factor not directly related to a decline          exclusions fits. A small problem should        (a) Residence - Treasury Regulation §
   in the value of the residence or to the           be noted. Combining and refinancing a              1.121-1(b)(1) requires a “facts and
   financial condition of the taxpayer.               non-qualifying and qualifying debt will           circumstances” test to determine
          In essence, the discharge can not          require attention to how the payments             what is a residence. Examples
   be “on account of” any factor “not                were applied to the debt - if to other            include houseboat, trailer, and house.
   directly related to” the decline in value         than interest - after the refinancing              Excluded is personal property that is
   or homeowner’s financial condition.                before the discharge.                             not a fixture under local law.
   In fairness, that limitation has enough        6. An insolvent homeowner faced with             (b) Principal Residence - Treasury
   flexibility to be of value and sufficient           restructuring a QPRI has two choices              Regulation § 1.121-1(b)(2). If more
   certainty to prevent wide spread abuse.           to exclude debt discharge income: the             than one residence, the facts and
   In an examination of a return for a               insolvency exclusion and the QPRI                 circumstances determine where the
   year in which debt discharge income               exclusion. The 2007 Act applies the               taxpayer resided for the majority of
   was excluded, the Internal Revenue                QPRI exclusion by default, unless the             the time in the 5-year testing period.
   Service (“Service”) will want to see              taxpayer makes an affirmative election
   documentation that confirms the                    to apply the insolvency exclusion. To        C. The Basis Adjustment: The Cost of
   “causes” of the discharge.                        make the choice, the adjustments to tax      the New QPRI Exclusion from Gross
          When restructuring the loan,               attributes resulting from an exclusion       Income
   the cause of the discharge should                 based on insolvency must be compared               IRC § 108 has always contained very
   be documented. Specifically, an                    to the one adjustment required for the       specific adjustments, meaning reductions,
   affidavit should be obtained from the              QPRI exclusion. For reasons defined           to a taxpayer’s tax attributes in exchange
   lender, affirmatively stating that the             in the discussion of “basis” below, the      for the exclusion of debt discharge
   homeowner did not perform services                insolvency exclusion should only be          income from gross income. More often
   for the lender. The Service would                 elected if the QPRI will not work. If the    than not, the effect of the adjustments to
   normally issue guidance defining what              amount of the QPRI to be discharged          tax attributes makes the exclusion from
   “directly related” to the homeowner’s             exceeds $2,000,000, then the insolvency      income a “deferral” as opposed to a
   financial condition might mean. Given              exception must be used due to the            permanent exclusion. The timing, when
   the lack of clarity in the statute, the           dollar limits of the new act. Practically,   the adjustments to tax attributes take place,
   absence of any explanation in the                 discharging over $2,000,000 should           require a very careful review to understand
   House Report, and the limited life                be done in a proceeding under Title          and to apply to a specific taxpayer.
   of the exclusion (three years), such              11, just to be sure that the bankruptcy            Not surprisingly Congress imposed
   guidance might not be issued.                     exclusion can be used.                       the same price for the QPRI exclusion. The
5. Qualifying debt and non-qualifying                                                             QPRI exclusion assumes, quite naturally,
   debt are discharged: The Ordering            B. IRC § 121: What is a Qualified                  that a homeowner will retain the residence
   Rule. New § 108(h)(4) defines how             Personal Residence?                               after the discharge. The homeowner’s basis
   the QPRI discharge exclusion will be              IRC § 121(a)’s
   applied when there is a portion of           “meaning” of             Example:
   a debt qualifying and a portion not          principal residence,
   qualifying. All of the discharged debt                                1. Residence Purchased for $3,000,000
                                                as described in §              Cash                                     $ 500,000
   income will be applied first against the      108(h)(5), limits
   “non-qualifying” loan, meaning no                                           Loan                                     $2,500,000
                                                application of that            Basis                                    $3,000,000
   exclusion. When a home equity loan           term to property:
   used to buy a boat is refinanced with
   an otherwise qualifying acquisition                                   2. Debt Restructured [QPR in California or Florida]
                                                 (a) owned and
   indebtedness, the ordering rule defines                                      Loan - reduced to:                       $1,500,000
                                                     used by the
   the excluded debt income. For example,                                      Debt Discharge:                          $1,000,000
                                                     taxpayer as
   the taxpayer buys a house, financed in                                       [$2.5 Million less $1.5 Million]
                                                     the taxpayer’s
   part with a loan of $250,000, acquisition                                   QPRI excluded                            $1,000,000
                                                     principal
   indebtedness. A year later the taxpayer-          residence;
   homeowner uses a home equity loan             (b) for a period        3. Basis Adjusted
   to borrow $200,000 to buy a new                   aggregating               Original Basis                           $3,000,000
   boat. Subsequently, the homeowner                 two (2) years or          Less QPRI Excluded                       $1,000,000
   refinances and consolidates both loans             more;                     Basis as Adjusted                        $2,000,000
   at a lower interest rate. The homeowner       (c) within the
   now has one loan of $450,000. Times               5-year period       4. Sale - 8 Years Later (Two Sales for Illustration)
   change; the homeowner and the lender              ending on the             First Sale                               $2,500,000
   restructure the debt with a forgiveness           date of (the sale         Less Adjusted Basis                     ($2,000,000)
   of $100,000. To the extent that any               or exchange)              Gain                                     $ 500,000
   portion of the home equity loan               (d) discharge.                Less - § 121 Exclusion - Joint          ($ 500,000)
   remains unpaid immediately before                                           Taxable Gain                             $     -0-
   the discharge, the $100,000 of debt               The Treasury
   discharge income would be applied            Regulations for IRC            Second Sale                              $3,000,000
   against the non-qualifying home              § 121-1 provide the            Less Adjusted Basis                     ($2,000,000)
   equity loan. The QPRI exclusion does         guidance on how                Gain                                     $1,000,000
   not work. The discharged debt must           to define a personal            Less - § 121 Exclusion - Joint          ($ 500,000)
   be reported unless one of the other          residence.                     Taxable Gain                             $ 500,000

10     Tennessee CPA Journal   |   MARCH 2009
in the residence is reduced, but not below      $500,000 in debt discharge income, some       from a taxpayer’s taxable income if §
zero, for each dollar excluded from gross       tax might be paid on the sale of the          108 is satisfied. More importantly, the
income, for QPRI discharged. Reducing           residence, maybe.                             QPRI income exclusion will have more
a homeowner’s basis in the residence                                                          permanence than other exclusions/
means that ultimately a taxpayer will           D. Form 982: The IRS Reporting                deferrals under Section 108 when
realize additional gain on the sale, or other   Requirements                                  combined with the exclusion of gain on the
disposition, of the residence.                        Any taxpayer that has discharge of      sale of a principal residence.
      Reducing basis in your home and           indebtedness income must file a Form
increasing the gain on the sale of your         982 with their individual income tax          About the Author:
home does generate an increased amount          return for the year in which discharged.           Wm. Robert Pope is an attorney at White
of income. However, Congress has                                                              & Reasor, PLC. He can be reached at bobpope@
                                                The Form 982 is captioned “Reduction
previously decided to exclude gain from                                                       whitereasor.com.
                                                of Tax Attributes Due to Discharge of
the sale of a qualified personal residence,      Indebtedness (and Section 1082 Basis
up to $500,000 on a joint return and                                                          References:
                                                Adjustment)”. Form 982 was revised              1. All references to the Internal Revenue Code of
$250,000 for an individual filing a separate     in February of 2008 to add the QPRI               1954, as amended, will be designated “IRC”. All
return. IRC § 121(a). Since the new QPRI        exclusion. Line 1e requires the taxpayer          section symbols and the use of the word section
exclusion has a cap of $2,000,000, some         to check a box to identify the discharge of       will apply to the IRC and not the Bankruptcy
taxpayers will have “basis adjustments”         qualified principal residence indebtedness.        Code.
exceeding the $500,000 gain exclusion on        Line 10b identifies the amount excluded           2. H.R. 3648; P.L. 110-142.
the sale of their personal residence.           from gross income. Form 982 comes                3. The compromise of a disputed debt is not a
      Congress viewed decreasing basis as                                                         discharge.
                                                complete with basic instructions for
a way of deferring gain until actual cash                                                        4. IRC § 108(a)(1)(A)
                                                consumer use.                                    5. IRC § 108(a)(1)(B). § 108(a)(1)(C) and (D)
is on the table. Debt discharge income will
                                                                                                  also excludes debt discharge income from
always be “phantom” income, i.e. taxable        Summary and Conclusion                            qualified farm indebtedness and qualified real
income without any cash. With personal               Congress has provided taxpayers              property indebtedness, respectively.
residence debt, Congress excluded debt          with an excellent but complicated                6. IRC § 108(a)(1)(E) and 2007 Act, Section
discharge income and required a basis           opportunity to restructure certain                2(d). The effective date is not stated in the
adjustment; but any gain from the sale of                                                         amended Section 108.
                                                unwise debt obligations for a qualified
the residence (under the statutory limits)                                                       7. IRC § 108(h)(2).
                                                personal residence. The 2007 Act gives the       8. Federal Income Tax 101: taxable gain equals
will be excluded from income.                   solvent homeowner a tax break that was            the sales price less the taxpayer’s adjusted basis.
      The 2007 Act gives a free ride to         previously available only to an insolvent         Therefore the homeowner will pay tax on the
the discharge of debt income from QPRI,         taxpayer or a taxpayer in a Title 11 case.        excluded debt discharge income when a sale
excluded from income on discharge and           Forgiveness of indebtedness income in             occurs, unless another exclusion applies.
excluded from gain on the sale. Over            a QPRI restructuring can be excluded




                                                                                                   MARCH 2009     |   Tennessee CPA Journal      11

				
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